Medicare Drug Benefits Plan Raises Value Issues for Buyers: Acquirers may overpay without calculating the law’s effects on targets with post-retiree medical care programs

Add the new Medicare drug benefits law to the list of mind-benders challenging acquirers in valuing a target. Difficulties spring not only from the complexities of the law but from the options that it affords employers and the absence of clear rules thus far in how to account for the financial impact of the act. The problems are especially acute if the target already provides drug benefits for its retirees, and the money involved is hardly small change within a purchase price because health care costs are among the fastest growing corporate expenses. At the very least, says the transaction services group at PricewaterhouseCoopers, the consequences of the law should differ from company to company and will require buyers to check out all the possibilities in performing due diligence on a target. Acquirers, the transaction group notes in a recent issue of its ts insights publication, must “understand how the new Medicare drug benefit will affect future reported earnings, free cash flow, pro forma EBITDA, and the balance sheet of any acquisition candidate that currently offers post-retirement medical and prescription drug benefits.” Additionally, the group warns that a target’s 2003 financial statements “may not provide reliable information for determining the impact of the act” since companies may delay or advance recognition of costs and FASB “final guidance” on accounting for post-retirement health benefits still is awaited. “That many companies will choose to modify their plans in response to the act will further complicate matters since the design decisions companies make will directly affect their future financial position,” ts insights comments. Possible outcomes – and effects on financial measures, valuations, and pricing – are widespread. For example, some companies may drop their post-retirement benefit plans completely and defer coverage to the new law. Conversely, in a bid to discourage the scuttling of company plans, the law provides employers with a tax-free subsidy of about 28% of the cost of a retiree’s drug bill that falls between $250 and $5,000 a year. In the accounting arena, where a comprehensive binding policy on treating post-retiree costs is still awaited, FASB staff positions allow companies providing benefits for former workers to defer the financial impact of the new law until various points in 2004. That is why the effects – regardless of how the company goes on various options – probably won’t show up in 2003 statements. “Prospective acquirers must be careful, since the combination of company discretion and lack of definitive FASB guidance means accounting treatments are likely to vary from company to company,” ts insights says. “Buyers will also have to account for the effects of the act at closing for any deal where fair value accounting dictates that (benefit) plan assets and obligations be measured.” The PricewaterhouseCoopers publication further warns that any buyer basing a target’s value solely on 2003 financial statements and ignoring implications of the drug benefits law “may miss a potentially significant valuation adjustment.” “For buyers using the multiple of EBITDA valuation model, the act is likely to favorably affect pro forma EBITDA and reduce the accumulated post retirement benefit obligation,” the advisory continues. “Beginning in 2006 (when full drug subsidies kick in), cash costs are likely to be lower for buyers using a discounted cash flow valuation model. The model should reflect that the federal subsidy will not be taxed at the federal level.” The publication further advises buyers to: * Check the language in acquisition agreement to determine whether it should be changed – “For example, is there a net asset adjustment that could cause the buyer to pay more than anticipated?” * Figure out whether the actuarial assumptions in the target’s health benefits plan are “appropriate” or whether they should be changed as a result of the new Medicare law. * Consider the possibility that future legislative changes could significantly cut the value of the subsidy distributed to employers. Copyright 2004 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com